Johnson Controls International plc (JCI) Earnings Call Transcript & Summary

Well, good morning, everyone, and welcome to Oppenheimer's 16th Annual Industrial Growth Conference. I'm Noah Kaye. I'm Managing Director and Senior Research Analyst in Oppenheimer's Sustainable Growth & Resource Optimization practice. And we are very pleased to welcome to the conference this morning, the CFO of Johnson Controls, Olivier Leonetti. Good morning, Olivier. Welcome, thank you for being here.

Good morning. Thank you for having us, Noah, and thank you for everybody to attend our discussion.

Well, great. And I think, actually, I'd like to start the discussion this morning with your high-level assessment. Since you joined the company about 9 months ago, certainly there have been some notable developments during your tenure already, which we'll discuss. Now that you've been with the organization for a solid period of time, I think the two high-level questions are: number one, what do you think doesn't get appreciated about this business from the outside that you can see better now working in the company; number two, what do you see as the single biggest challenge in front of the company as we sit here today?

Yes. So I don't know if I would use the word underappreciated. But before I joined, George and I, the company and I, took a fair amount of time before to decide each other. We got the opportunity to understand each other and to -- I got the opportunity to understand also where Johnson Controls was in its path. And I joined for a variety of reasons, the culture, the whole -- the team [indiscernible] our organization, finance and procurement that I represent to play, the connection with George, the strength of the end markets. I joined for all those reasons. And what I believed at the time, and today, I even more believe, a stronger belief on this, is Johnson Controls has now created a unique platform which is now ready to deliver its full potential. So 4 years ago, the merger took place, it took time to put together the management team, to put together a strategy, to put together an operating system, and we're ready now to execute. And I knew we were ready to execute. And I believe that now we're starting to put points on the board and execute better. So I'm not so sure we'll talk about misunderstanding. But I believe today, we are ready to be delivering our full potential and we'll discuss about what that is, I'm sure, today, Noah.

Absolutely. And in terms of the challenge or any single biggest challenge?

Let me -- what -- let me tell you what the challenges are not. The end markets are strong. I think the building business is facing one of the best decade it has been faced as an industry. I think that the challenge is not our capability to compete. I think actually we have the right assets for the time. When you speak about the decarbonization of buildings, smart buildings, we are uniquely positioned. We have the resources to compete. We have the cash to compete. We have the talent to compete. As always, as you go through a transformation, and all of us are transforming, the key success factor is people. We have a high level of engagement among our team members. And can we keep that going on? Could we keep innovating? Could we keep having an entrepreneurial spirit? Can we keeping agile? Those are the challenges we always have to face. Because the rest is there. It's for us now to execute and seize the opportunity.

One of the many interesting things about your background is the credentials you bring in the information technology space. You were the CFO at Zebra, Western Digital. I'm leaving out some other highlights, but people can look them up. The OpenBlue platform that JCI launched is obviously a major digital initiative of the company. How in your view can the company continue to improve this platform? And how do you monetize it more effectively?

Every -- more or less every industry in the planet as part of its strategy, a digital component. And it -- I would argue it's good to be what is making the differentiation for many, many industries. It's no exception for us and it's no exception for Johnson Control. Digital is part of everything we do, smart devices, smart services, smart building, to drive indirect quality to drive decarbonization, it's today digital everywhere. And we are ramping those capabilities. Having a building management system is not enough, you want -- you don't want to connect a huge chiller in a building with one system. You want to connect all the chillers you have in the world in one platform and mine the data. That's what you want to do. And we have today created that capability. And we see -- then the question is how do you see it? I mean you asked us the question last Friday during our earnings after calls. We see it in the conversations we have with our customers. Before, we used to talk to the building manager or even a contractor. Today, the conversation is a C-suite to C-suite conversation, so George interfacing with the largest -- George is our CEO and Chairman, the largest CEO of the largest company in the world to drive the decarbonization of our customers' footprint. So -- and you can only do that because you have a digital. So digital appears in the conversations we have. Digital appears in our ability-to-win mode. Our win rate when we put digital is higher. The margin rate when we put digital is higher. So today, we see a sizable impact of digital in our ability to compete. And we believe we are just at the start. We'll keep announcing what we do to transform digital at Johnson Controls, either from a product standpoint, from a partnership standpoint or from a design standpoint. So we're just at the start of this journey.

Yes. And I know driving the services attach rate higher from the current penetration of the installed base, specifically in the mid-30s, core organic growth focus, a mix tailwind. Can you talk to us about the gating factors you see on getting penetration higher and how, through incentives, product development, digital, as you just mentioned, and otherwise are you overcoming those gating factors and then drive the attach rate higher?

So if you look at our services business, it's a $6 billion business. And the profitability of the service business is double all in the one of the enterprise. So it's really a profitable business. And when we look at the attach rate for services, the attach rate today is about 35%. And we believe that digital and focus will drive a higher attach rate. Let me tell you where we are now with the attach rate and what we're doing to keep improving it, which is your question. So attach rate at the end of last fiscal, which was September last year, attach rate was 35%, 3-5. And we said over the next 4 quarters, over the next fiscal, we want to improve the attach rate by 4 points. At the end of 2 quarters, March quarter, which is our second quarter, we had increased the attach rate by 3 points already. So our ability to attach is increasing. Why? A few things. One is what you would call operational discipline and then two is the power of digital. Operational discipline, you will include go-to-market. So we have an overlay now for services. We have a central practice for the world of driving services at Johnson Controls. We have a differentiated compensation program to incentivize everybody on services. We have a different set of training to sell services. And we have also launched new offerings. So you have a new operational discipline behind digital. That's one. And two, and that's very important, the service business today is a mechanical service business and it's a local service business, local competitors.

[indiscernible]

Exactly. As you move to a digital service, you change the game. And then we believe we are going to build a revolution, us and our peers, in the service business because of digital. If you connect all the chiller you have in the world, not only in one building but across the world, the amount of insight you're going to drive is going to create a formidable competitive advantage. So these advantages are also part of why we will start to see increase in attach rate and why we believe this business will grow probably faster than the company average going forward. We are very pleased with what we are starting to see in this business.

There's an iterative process that we're seeing here. I mean the more field data you're collecting on your connected assets, the better your insights will be, which widens the competitive advantage against [indiscernible] alternatives. And so one would think that over time, that will prove to be sustainable. I mean that's something you think about. Tell us about that.

Yes. I mean, again it's intuitive, right? If you have smart devices, if you drive a lot of insight from it, then you start to do preventive maintenance. You start to do retrofits. You can really optimize how you are running a set of assets. So it's, we believe, a key success factor.

Yes. And that actually plays into my next question. I think it was notable that your installers outperformed the end markets last quarter on the strength of retrofit. You also talked more about your performance contracting business, the potential to do more outcomes-based contracts in the C&I space. And all this is happening in the context of, as we mentioned before, the whole question to the decarbonization of buildings. So can you talk about some of these areas? Can you talk about demand trends for performance contracting, prospects for more C&I customers to adopt a similar structure? Any kind of financing tools you're looking at to help projects be net cash flow positive to customers as they're doing these projects?

Yes. So first of all, if you look at the theme of decarbonization, right, the governments are pushing for decarbonization in our country, in Europe. President Xi in China is pushing for this. The cities are pushing for this. The cities that are not pushing for this, if you look at Germany, who are going to have elections soon, the Green Party is going to be strong. So there is a big push for decarbonization. New investors are pushing for also ESG, which has in its -- in part decarbonization as a theme. BlackRock, they said, "We're not going to vote for your Board if you do not decarbonize. I want you to deliver great financial results. But you need to do decarbonization as well." So you have a huge push going on. And we believe that we're uniquely positioned to materialize on this trend. Why? To decarbonize, you need to have smart devices. You need to sense a lot. You need to analyze what you have sensed and then you propose an action. If you look at Johnson Controls, we have the largest installed base of equipment in buildings in the planet compared to anybody else. And we're connecting faster and faster those devices and analyzing the outcome of this collection in our OpenBlue digital platform. And then we have the ability to drive insights from those data and propose an action through one of the largest fleet of engineers in the industry, 16,000 of them. So we have a formidable platform. Now you can say, "Okay, that's nice. How do I sit?" We said it on the call. If you look at the U.S. market, we have a market called the energy saving and performance contracting market. It's a $4 billion market, where today, you are paid based upon outcome. We have a leading share in this market. Actually, we have a market share which is close to 20%. And our #1 competitor has a market share which is 50% smaller than us. So we have the ability to do decarbonization, but we are doing it today. And we believe that this model, we're going to now starting to emulate, replicate it more and more. Now you talk about financing, Noah. We have created [ Johnson Controls Capital ]. So we are financing projects today ourselves in our balance sheet and then we sell to that later. It's a very attractive way to win deals. And we're working also on more sophisticated arrangements. So we'll keep you posted soon about those changes in financing. But financing is today part of the competitive advantage we have and more to come.

[ JCI Capital ], is that primarily to fund the SPC business? Or is that more for the C&I side? Because historically, there's always been a big opportunity to do C&I retrofit and the question was always how. How does that get paid for in an outcomes-based way?

We will finance today in -- I mean, of course, we need to assess credit and so on. But we're going to be agnostic to what we finance. If this is an ability to close a good deal, we will use financing, not only for a set of verticals. But decarbonization today -- because you could go to a customer and say, "I've done an audit of your place, I can help you to save energy. I can help you to decarbonize. And by the way, I have a financing ready." And by the way, the financing is very attractive because today, we have many lenders who need to put their money into clean investments. It's ready to go. High ROI, that's how we go to market.

Very helpful. I think one of the most frequent questions we get on the company is really about business strength in a post-pandemic world. And some of the surveys we've seen indicate that corporate America still expects a substantial minority of employees not to return to the office as reopening progresses later this year. Do you see potential for a longer period of underinvestment relative to historical levels in commercial buildings? How does the company sustainably outperform the end markets and generate positive organic growth?

So if you look at today, you have vectors which are creating a revolution for the building industry. And I would say the revolution is going to make this decade one of the most exciting decade for the building industry. And what is this revolution? One is, and it's public data, 80% of the footprint in buildings is equipped with equipment which are more than 20 years old. Technology has changed a lot. So you have this vector. Second vector, we have now the technology to fundamentally change how a building perform in carbon emission, in clean air. So we have new technology. We have new technology which is amplified in its impact through digital. That's a third thing. You have financing ready, we talked about that. You have pressure today from the community, we talked about that. So we believe that now the building industry is going to be growing faster as an industry than GDP. And we believe that at JCI, we are uniquely positioned to materialize those trends. We talked about that earlier, Noah. You want to sense, analyze and act on the data. And we have this ability. Because it's easy to do clean air. You make your machine turn faster. But clean air, if you don't do it -- if you do it in a non-smart way means more carbon emission. You can increase your carbon emission by 50%. So you want clean and smart. Again, we believe we have the ability to do that. So we think it's going to be an exciting set of years for our industry. I mean all of us are trying to compete to get an unfair part of this market, we think we are uniquely positioned. And it's starting to show in the market.

I just wanted you to briefly touch on the COVID relief bill that had $110 billion in funding for K-12 schools. Are you seeing anything now in the education segment in terms of incremental pipeline? And how significant a revenue boost could that be?

So we have large stimulus in the U.S. If you look at just the K-12 stimulus, it's $195 billion alone. And we have a strong presence in all the verticals where the stimulus is going to be mainly used: health care, education, government, airports. Those verticals are the verticals where we have the -- our highest market share. And we have teams across the 50 states today who understand the relief package and have today shovel-ready solutions for our customers. Now the question is where do you see this? Do we see it in the P&L? We said that on the call on Friday. Our installed business -- first of all, revenue for us is a lagging indicator. The revenue for Johnson Controls was based upon orders largely, not only but largely, booked in the middle of the pandemic, 2 quarters, 3 quarters ago. So if you look at orders, which is the true velocity of the business today, if you look at orders for in-store, we had a growth of 9%. And usually, in-store growth is driven by equally retrofit and new building. But there is no new building today. The new building business is flat. All the growth in installed is coming from retrofit. A large part of this is generated by this stimulus incentive that we are materializing. So we have a high presence to materialize our ability to capture the stimulus and you start to see it in the P&L. And we believe that's just a start. And by the way, the new building business is starting to pick up. So we believe that we have an exciting future in front of us, no question about this.

Very helpful. I want to turn now to the M&A side of the business. Given the company recently announced the agreement to acquire Silent-Aire, a data center cooling provider, this would be the largest acquisition since the Tyco merger. So a couple of questions that we've been getting on this one. First, why was now the right time for the company to be making large acquisitions?

So if it's the right time, now we believe we have clarity of strategy, clarity of our operating system. We have a very aligned leadership team. We have a strong cash flow generation, so ready now to do M&A. We're ready to integrate an acquisition. And we believe, George, our CEO and Chairman, has said many times, we have the ability to generate 1 or 2 points of additional growth, top line growth, profitable growth, through M&A. And we're going to play in 3 areas. First of all, by the way, there are going to be tuck-in acquisitions. We want to keep our leverage of 2 or 2.5 leverage ratio. And we're going to play in 3 areas for M&A: one, product addition, that's Silent-Aire; two, services contract; and three, digital capabilities. So that's what we are trying to do.

Can you talk a little bit about the fit of Silent-Aire within the portfolio? How does data center cooling complement your current offerings and your customer base? And what can you do to really maximize the value of that acquisition to the company as a whole?

So if you look at Silent-Aire, so data center is an important vertical for our industry. That's not the most important vertical, but it's an important one, growing fast. And we have a relatively lower market share in this vertical. So the asset allows us to double our market share in this vertical. And we like the asset for a few reasons. One, it's a high-quality asset growing at about 40% top line over the last 5 years. Actually, the growth rate is accelerating. We like the business. We like the people. We thought it was a great cultural fit. We don't have the time to talk about Silent-Aire here, but it was created by a dad and a mom and their 2 sons took over the business, are doing wonders with it. So we believe we're going to have a reverse integration. We have said to the Silent-Aire brothers, they're going to stay with us, by the way, for 3 years or more if they want to, "We want you to tell us how to be as successful as you are." A great cultural fit, we love the product portfolio, we love the technology. And we believe we're going to be able now to offer to Silent-Aire our go-to-market for them to deploy even more broadly their products to the market, particularly in Asia. So we are very, very excited by this partnership.

Well, I think as we think about further M&A, you've addressed some of the types of focus areas you have. Can you just give us a sense how active is the leadership in exploring M&A at this point? And is this sort of structurally a frequency of M&A meetings, discussion? How involved are you? How involved is George? Give us some color there.

So there are 10 activities today we look at as a management team. So all the leaders of the organization, it depends on the forums, about 40 of them. All of us look every week 10 set of activities. Cash generation is part of it. Productivity initiative is part of it. Services is part of it. Digital is part of it. Part of it is also the M&A pipeline. So it's -- we review the pipeline for M&A every week. We have augmented our capabilities in the field. We have now teams which are totally specialized to scan the market and the pipeline is growing nicely. And we will be, as any other company, prudent and diligent and thoughtful. But more exciting things will come from an M&A standpoint.

We look forward to that. And thank you for the color, it's helpful. I want to turn to the cost reduction initiative you announced last week, planning to reduce COGS by $250 million by 2023. That complements the $300 million SG&A savings program you announced in February. Obviously, there's a myriad of puts and takes on margins for the next few quarters, just given how strange last year was and some of the cost actions you took during the height of the pandemic. What's the best way for investors to think about incremental margin trajectory going forward? You can answer on a near term or on a multiyear basis, whichever seems more addressable.

So if you look at -- I mean, if you look at the DNA of the company, we are building a great muscle in terms of operational discipline. Now if you look at -- just to give you a proof point, I will answer to your question in details in a second. For the second half of this fiscal, we're going to be able to increase the level of profit rate for the company despite very tough compares. Because last year, we were able to implement furloughs. We had nobody to call. We stopped everything, right? But despite this, we are now ramping the business. We're able to improve profit rate, strong control on cost. And at the time, we had the best management of the P&L in the industry by a margin. We have -- we know -- I mean, you knew this, you have told us that for a period of time, we were lagging profit relative to peers because of too high cost base. The reason for the high cost base is we have a very decentralized business. We have created one company but still very bespoke processes across the globe. We're now fixing this. We're fixing this and that will impact COGS, that will impact also OpEx. And we believe by the implementation of those programs, which are net, we will be able to catch up, I would even argue, pass the very best in the industry from a profit rate. We gave you the road map for this. And if you do the math, we will have 40% incremental next year, 40% incremental the year after that. And then we'll see. We believe we'll keep adding the capability to create a very attractive incremental. But clearly, we are on the cost agenda. And we have a high level of confidence on our ability to deliver on those programs.

Very good. And I just want to remind folks, if they have any questions to submit you can submit them via chat function. We've been very involved in our firm's effort to support the growing ecosystem of ESG initiatives, reporting transparency, investor education. I think certainly, from our perspective, JCI has been a real leader in terms of their reporting transparency, also made a number of commitments around reduction of emissions, energy consumption, waste generation, supplier diversity and so forth. As a CFO, how do you think about, from the bottom line perspective, the ROI on those commitments? How do you systematize that on a firm-wide basis? Can you give us an example or 2 of some of these initiatives, where maybe it seemed a little bit onerous but ended up penciling out well? How do you bring the financial discipline to put it through some of these commitments?

Yes. Mind you, I mean we have a baby in the background, Noah. I'm a CFO, but I'm also a dad and a citizen of the world. I give you a story. We don't have a ton of time, I can go off track here. So Charlotte, we have 3 kids. We spend a lot of time at the dinner table. Charlotte, about 2 months ago, said, "Daddy, what do you do to save the world, the planet? What is Johnson Controls?" So I have an incentive at home to do this. It's an incentive at home, an incentive from our employees and incentive from the investment community, an incentive from many parties. So it's -- we have to do it, it's just smart to get it done. But it's also right for the bottom line. So we were one of the first companies to do green bonds. It's cheaper. It's good for the planet and it's cheaper. And we see ESG today as a way to drive R&D. It's a forcing function for us to deliver clean products, cleaner solutions. And those are going to be intimately winning in the marketplace. So it's right for Charlotte, our daughter, but it's right also for our customers and for us to drive value. Again, I go back to the earlier conversation, George, our CEO and Chairman, is having a conversation with some of the largest companies in the planet because we have this offering. And this offering is driven by this ESG quest, this ESG strategy.

Yes. I mean, I think there's some learning you do as well, right, in terms of reducing the carbon footprint of your own facilities and then how you put that into practice across your performance contracting business, your product development business, all of that. Can you talk a little bit about that kind of impact in terms of the learning cycle on how these internal efforts end up driving some of the more competitive products in the field?

So let me give you maybe some statistics about buildings, right, and carbon emission. So 40%, 4-0, we had a slide on our earnings call, 40% of the carbon emission in the planet is generated by buildings one way or another, 4-0, 40%. HVAC generates 40% of the 40% of the carbon emission of a building. And we have now the technology to decrease the carbon emission to HVAC by 50%. So you can do the math, 40 divided by 40 divided by 50, that's a big number. And today, we have deployed a new business model of solutions, of financing a new go-to-market to leverage this opportunity. And we believe that this business of decarbonization is a $100 billion-plus business for the industry over the next 8, 10 years. And we see this industry ramping up. We don't have enough time here. But look at the city of New York in our country and the -- now the penalties are increasing and increasing. And this trend is not going to stop. So we think it's going to be great for the planet but also great for the industry and great for Johnson Controls to decarbonize buildings.

Yes. I think just the leverage to that secular trend is a very positive part of the company's value proposition. I'm glad we got a chance to talk about it today. And obviously, very much appreciate you being here. Certainly, if anyone has some follow-up questions for myself or the company, you can always e-mail me at [email protected]. But for now, we want to thank you again, Olivier, for being with us. We hope everyone has a great day here at the conference. You take care, and we'll see you soon.

Thank you for having us, Noah, and thank you to everybody for listening. And you take care everybody. I had a lot of fun. You take care, Noah.

You, too. Bye.